from Follow the Money

It wasn’t just the market ...

February 2, 2009

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James Saft of Reuters worries that the crisis will lead to a shift away from the "Davos consensus," especially as the market’s power had pulled so many out of poverty.

"the stuff underlying the Davos consensus really was pretty good at doing lots of things, not least raising living standards in huge swathes of the developing world. States aren’t traditionally all that great at allocating resources either"

Reasonable point.

But the narrative of the past six years isn’t really one defined solely by the retreat of the state and a greater role for markets in allocating resources in the developing world. In both China and many fast-growing (until recently) oil-exporters, the state played an active role in guiding investment decisions. It thus was helping to determine how resources were allocated across sectors.

-- Most Chinese investment, as Nick Lardy and Morris Goldstein pointed out a while ago, is financed domestically. And a lot of that investment is financed by the retained earnings of state firms or by loans from state banks. Perhaps all of these investments were done on a purely commercial basis, but there was certainly scope for the state to guide the allocation of resources.

-- Most oil exporters have powerful national oil companies that control the oil revenue stream. And a lot of "private" investment in Gulf came from banks and firms that were either owned by the state or by the "palace." A host of firms borrowed not on the basis of the strength of their own balance sheet but on the perception that they were too close to the state to fail. Dubai is often presented as a model of free-wheeling capitalism. But Dubai, inc remains closely tied to the palace.

Simeon Kerr and Roula Kalaf of the FT:

"Dubai’s sprawling business empire spans government institutions and private companies owned directly by Sheikh Mohammed but acting as quasi-government bodies. The ruler has instituted a culture of competition among state-backed companies and insisted they run themselves as private sector entities. In their quest to satisfy his ambitions, the business groups have come to rely heavily on debt – leveraging myriad commercial ventures, from domestic property developments to international acquisitions. Along the way, Dubai’s finances have become complicated and the line between ruler and government assets blurred.

It turns out that state backed companies weren’t borrowing as private sector entities -- or at least no one who was lending them money thought so. They were able to borrow so much largely because of their state backing. And now, given Dubai, Inc’s cash flow troubles, Dubai, Inc may soon morph into Abu Dhabi, Inc.

-- Exchange rate policies can also influence the allocation of resources across sectors. China’s de facto dollar peg is an obvious example. Pegging to the dollar as the dollar fell from 2002 to early 2005 produced a large real depreciation in the RMB. The RMB then rose v the dollar, but never by enough to fully offset the dollar’s fall. The BIS estimates that China’s real exchange rate was weaker at the end of 2007 than at the end of 2000 -- even though China’s exports grew by a factor of five during this period. The nominal and real depreciation of the RMB encouraged foreign firms to set up shop in China and encouraged domestic investment in the export sector; it is hard for me to believe that as much would have been invested in China’s export sector if China had had a different exchange rate regime.

China’s policies also influenced -- in all probability -- the global allocation of resources. Before the recent crisis, remember, private capital wanted to finance current account deficits in the emerging world, not the current account deficit associated with the US household sector’s borrowing need. By holding US interest rates down and the dollar up, China’s policies discouraged investment in tradables production in the US while encouraging investment in the interest-rate sensitive sectors that weren’t competing with Chinese production. This isn’t too say that the US didn’t already have a slew of policies in place to encourage investment in housing. It did -- from the Agencies to ability to deduct mortgage interest from tax payments. But the surge in demand for US bonds from the world’s central banks reinforced those policies. Larry Lindsey argued -- I think correctly -- that China’s policy of spending huge sums - to keep its exchange rate from rising, China often had to spend 15% or so of its GDP buying foreign assets -- to avoid currency appreciation didn’t affect overall levels of output or employment in the US, but it certainly affected the composition of output and employment. More money was allocated to home construction (for a time) and less to investment in the production of goods for export than otherwise would have been the case.

My point is simple: A lot of global growth during the boom came in countries where the government owned or influenced the domestic banking sector and thus influenced the domestic allocation of credit. And policies that kept exchange rates lower than they otherwise would also indirectly encouraged private investment in those countries export sectors as well as discouraging investment in the export sectors of other countries. Governments were playing a significant role in the allocation of capital even before there was any talk of nationalizing the financial sector of key G-7 countries. Those who attribute the growth of the past several years solely to the market miss the large role the state played in many of the world’s fast growing economies. Conversely, those who attribute all the excesses of the past few years to the market miss the role that governments played in financing many of those excesses ...

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